Tuesday, 25 September 2018

“Not impossible” Fed whistling in the dark

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  • James Saft - June 2014

As it must, the Federal Reserve is whistling in the dark, maintaining a brave front over its willingness, some day, to raise interest rates while events and markets both move against it.

The risk is that even as the US central bank dovishly capitulates towards market expectations, confidence about how it will react diminishes as gaps between its forecasts and promises and its delivery grow. That might explain why Fed dovishness was met, this time, with a falling stock market.

The Fed kept rates at between 0.25 and 0.50% on Wednesday, extending at least until next month a long pause since its first hike of this up cycle in December.

Fed projections of where interest rates will go, as embodied in the “dot plot”, moved down for the longer term but remained at 0.90% at year’s end. Yet futures traders also downgraded their expectations for later this year.

Asked about a rate hike in July, an outcome to which markets assign a 7% chance, Fed Chair Janet Yellen’s tone became almost pleading.

“No meeting is out in terms of a possible rate increase. But we really need to look at the data and I can’t pre-specify a timetable so I’m not comfortable to say it’s in the next meeting or two but it could be,” she said at the post-announcement press conference.

“It could be. It’s not impossible. It’s not impossible that by July for example we would see data that led us to believe that we are on a perfectly fine course, and that data was an aberration and that other concerns would have passed.”

So, Janet, are you saying it’s not impossible? It really could be?

Yet the data she was presumably referring to as an “aberration” – last month’s poor US employment figures – is only an outlier when you look strictly at that particular data series. Yellen is quite correct that this month’s jobs figures may reverse course, but there is no lack of other indicators which show she and her colleagues have plenty to worry about.

Data this week showed total capacity utilization falling to 74.9% in May from 75.3% in April. Economists at Deutsche Bank pointed out that the last two times capacity utilization was close to 75%, both demand and inflation were weak.

Low low low expectations

The sort of poor pricing power associated with low capacity utilization perhaps explains the disappointing corporate capital expenditure figures. Why invest when demand is weak, inventories are high compared to sales and inflation is very low?

The Fed kept up its brave face in discussing longer-term inflation expectations, acknowledging that market-based measures fell but maintaining that “most” survey-derived barometers of inflation expectations changed little.

Third, the statement expressed slightly more concern about developments in inflation expectations, noting that market-based measures “declined” (instead of “remained low”), and that only “most” survey-based measures were little changed “on balance” over recent months.

Perhaps, but five-year inflation expectations as measured by the University of Michigan are now as low as they’ve been in that consumer survey’s 37-year history.

One unnamed FOMC member broke ranks to say they expect it to be appropriate to hike once this year and then not again in 2017 or 2018.

“This is consistent with our view that a further softening in labour markets could signal a significant shift in Fed policy. This is not our baseline assumption, but we raise the point to say that Fed policy feels bi-modal as labour market data have historically sent a strong signal about expansions and contractions,” Michael Gapen and Rob Martin of Barclays wrote in a note to clients.

If that happens, the Fed and financial markets will have a problem. It is ominous that Fed dovishness is no longer inspiring much enthusiasm for risk assets. This may reflect a loss in confidence in the central bank’s ability to stimulate demand if needed.

We already have a downturn in corporate profits, corporate investment and capacity utilization, and perhaps an emerging downturn in employment, all at very, very low interest rates and after only one solitary increase.

If the economy is not great with rates at 25bp to 50bp it is hard to see it getting much of a boost from zero, and we all now understand how problematic negative rates can be. Using more QE for a garden-variety downturn would also raise unpleasant questions about the state of the economy.

Whistling and hoping may not be much of a strategy but for now they are all the Fed, and we, may have.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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